Controlled Companies Carry Negatives

A new study finds that controlled companies – particularly those with multiple classes of shares – generally underperform over the long term. As compared to companies with dispersed ownership, controlled companies experience more stock price volatility, increased material weakness in accounting controls, more related party transactions, and offer fewer rights to unaffiliated shareholders. The study results challenge the notion that multiclass voting structures benefit a company and its shareowners over the long term.

The study, Controlled Companies in the Standard and Poor’s 1500: A Ten Year Performance and Risk Review (PDF), was commissioned and funded by the Investor Responsibility Research Center Institute (IRRCI) and conducted by Institutional Shareholder Services Inc. (ISS). IRRCi and ISS  hosted a webinar to review the findings on Monday, October 8, 2012. Download the PowerPoint presentation and/or webinar.

Most U.S. companies feature “one share, one vote” governance provisions to allow voting power to elect directors that is directly proportional to an investor’s capital at risk. For a growing number of companies, however, voting power is concentrated through the use of different share classes to allow insiders or founders to control board of director elections.

The study discusses a recent quartet of high-profile technology companies that went public with such multiclass governance structures. Of these four, only Linked In has rewarded investors as of August 31, 2012, with a 138% stock price increase since its initial public offering (IPO). The stock prices of Zynga, Groupon, and Facebook are far below their initial public offering (IPO) prices by 72.0, 79.3 and 52.5 percent, respectively. However, the issue of multiclass ownership structures extends far beyond these recent technology sector companies.

As I mentioned back in May after attending a meeting of the SVNACD:

My biggest takeaway from the meeting was the apparently growing opinion in Silicon Valley that rating agencies, such as ISS and Glass Lewis are so powerful and use such a badly designed and executed check box approach that companies increasingly feel the need for dual class structures. Further discussion revealed that most (not sure about Facebook) are being structured so the dual class expires with the death of the founder.  At least that’s better than carrying the legacy down through generations.

Yet, dual class structures are antithetical to the wishes of institutional investors. See, for example, the discussion at Weathering a Crisis: Weil in Silicon Valley.  GMI Ratings has already identified over 200 dual class publicly traded companies in the Russell 3000. Read Kimberly Gladman‘s insights concerning where dual class shares have led radio broadcaster Emmis Communications [NASD:EMMS] on the HLS Forum on Corporate Governance and Financial Regulation, The Dangers of Dual Share Classes.

Key findings of the IRRCi/ISS study include:

• The number of controlled companies has increased over the last decade. In 2002, there were 87 controlled firms in the S&P 1500 Composite; today, there are 114. Of these, 79 feature multiclass capital structures with unequal voting rights and 35 are controlled firms with a single class of voting stock.
• Contrary to the theory, non-controlled firms outperformed controlled firms over the 3-year, 5-year and 10-year periods ended August 31, 2012. Controlled companies featuring multishare classes only outperformed over the shortest time period measured – one year – and materially underperformed over longer periods of time. By contrast, control companies with a single share class outperformed all others over longer time periods. The nature of the control mechanism appears to matter.
• Controlled companies with multiclass structures consistently exhibit materially more share price volatility than non-controlled companies. By contrast, controlled companies with a single class of shareholders consistently exhibit more share price stability.
• Controlled companies have more material weaknesses in control environments than non-controlled companies.
• Controlled companies have more related party transactions than non-controlled companies.
• Institutional investors cite concerns with investing in controlled companies, but generally do not have formal policies concerning such firms. Most investors report that controlled firms are less responsive to their inquiries and engage in less outreach than non-controlled firms.
• The governance provisions of controlled firms with a single class of stock often differ from those with multiclass capital structures, and in some respects more closely resemble those of non-controlled firms. Controlled firms with a single class of stock have more conventional governance features with respect to board accountability and shareholder rights compared to controlled firms with multiclass capital structures.

“Investors have long taken a limited view toward controlled firms with multiclass capital structures because of such structures’ inherent negative impact on the rights of unaffiliated shareholders,” said Sean Quinn, report author and vice president with ISS. “This study finds that in addition to offering unaffiliated shareholders comparatively fewer rights, these firms underperform and show higher levels of risk than their single-class peers,” he said.

“Recent IPOs have thrust the issue of multiclass companies into the spotlight,” said Jon Lukomnik, IRRCi executive director. “Supporters of these structures claim that control of a company’s voting power enables management to govern with minimal outside interference and focus on long-term business growth, and ultimately deliver higher returns to shareholders in exchange for control rights.”

However, the study finds the opposite to be true. When control is exercised through multiclass structures, those companies perform worse and are more risky. In contrast, when company control is aligned with unaffiliated investors in a single class of stock, the result is companies perform better over the long haul and are less risky. Alignment matters. The method of control matters.

In this study, the definition of control included any person or group owning 30 percent or more of a company’s voting power. The study examines firms in the S&P 1500 Composite Index as of Jan. 1, 2012, and discussions with representatives of six institutional investors and two investment banks to provide context to observable findings.

Coverage of the report by Compliance Week, Dual-Class Shares Get Double Teamed by Critics, 10/2/2012.

Also interesting to note, provisions that normally empower shareowners sometimes have the opposite impact at controlled companies. For example, eliminating supermajority requirements or allowing a those with a majority of shares/votes to act by written consent can eliminate even any meaningful ability of minority shareowners to protest actions.

The problem isn’t going away. In fact it is increasing. Out of 122 IPOs between 1/1/2010 and 3/28/2012, 48 involved controlled companies. Of course, another finding that goes along with controlling shareowners is that such companies feel less obliged to communicate and consult with other shareowners. Outreach can be minimized. So far, having a controlling shareowner and/or a dual class structure appears to have little impact on the IPO… it hasn’t been an obstacle. However, that may change.

CII Urges NYSE and Nasdaq to Take Action

Concerned about the number of public multi-class stock companies and the resulting potential for harm to shareowners, the Council of Institutional Investors urged the New York Stock Exchange and Nasdaq to make new companies that have two or more classes of common stock with unequal voting rights ineligible for listing. (10/2/2012 press release) According to Anne Sheehan, Council chair and director of corporate governance for the California State Teachers’ Retirement System:

These structures are troubling because they pose greater risks to investors and foster less accountability from boards and company insiders. Not only is this multi-class structure inherently unfair, there is ample evidence that multi-class stock companies do not perform as well as one-share, one-vote companies, are more prone to abuses such as excessive CEO pay and related-party transactions and are more likely to take actions that conflict with the interests of their shareowners.

The Council’s executive director, Ann Yerger, said:

Not only is this multi-class structure inherently unfair, there is ample evidence that multi-class stock companies do not perform as well as one-share, one-vote companies, are more prone to abuses such as excessive CEO pay and related-party transactions and are more likely to take actions that conflict with the interests of their shareowners. When a company goes to the capital markets to raise money from the public, public investors are entitled to certain protections and basic rights, including a right to vote that’s proportional to the size of one’s holdings.

There is no evidence that a multi-class stock structure is imperative in order for a company to succeed. For example, some of the most successful companies in the technology/Internet sector – including Apple and Amazon – are known for having visionary founders and yet they all operate as single-class stock companies. Prohibiting new public companies from adopting multi-class stock structures would go a long way toward enhancing public market integrity, safeguarding public investor rights and restoring investor confidence.

CalPERS May Boycott

As I reported previously, CalPERS is considering a policy of not investing in the initial public offerings (IPOs) of dual-class companies where shareowning is structured so that a minority will control the majority of the votes. From what I have seen, CalPERS has already opposed those that exist but this step would allow the retirement system to avoid purchasing shares in such companies as they enter the market, even though they may be included in various indexes included in the fund’s portfolio. (See CalPERS May Boycott Dual-Class IPOs)

Proxy Advisor Contests May Help

As I noted then, one way to address the possibility that some companies go to IPO with dual-class offerings because they don’t want to deal with proxy advisors is to incentivize proxy advisors with more money.  I am working with Mark Latham of VoterMedia to remedy this problem. See Costco: Proxy Advisor Contest Proposed, which not only would pay proxy advisors enough money to do more firm-specific research (getting away from a cookie cutter approach), but would also create more competition between them and would ensure their advice goes to all shareowners (not just subscribers), and that they are paid enough to devote the necessary resources to fully analyze companies, especially their unique circumstances. Let’s not march toward dictatorship just because it is easy. Democracy takes a little more work but pays off in the long-run because more brains are engaged.

Unfortunately, Costco din’t see the advantages of our proxy advisor contest proposal and submitted a “no-action” request to the SEC.  Our response is posted on the VoterMedia.org Publications/Proposal page. I’m under no illusion that such proposals will be widely adopted in a year or two under private ordering or that even if they were, dual-class structures would suddenly lose their appeal. However, I do think proxy advisor contests would engage and inform more shareowners, would allow proxy advisors to do better research, would ensure advice is more widely disseminated and would take away at least one excuse for proposing dictatorships through the IPO process.